SEP Contribution Limits

The maximum amount that can be contributed annually by an employer to an employee's simplified employee pension (SEP) plan account is the lesser of an amount equal to 25 percent of the employee's compensation for the year or $51,000 in 2013 ($52,000 in 2014.) The limit is subject to adjustment for inflation annually. In addition to the employer's annual contribution limit, if the plan is a salary reduction SEP (SARSEP), employees' elective contributions can be made through payroll deductions from the employees pay.

Example Catherine LeGrande earns $220,000 in compensation from her employer prior to any contributions made to her SEP in 2013. The maximum amount that Catherine's employer may contribute to her SEP in 2013 is $49,000 (25% x $220,000, or $55,000, being greater than the $51,000 limit).

Amounts contributed by the employer are not taxable as income to the employee in the year they are contributed if they don't exceed the limit for the year. In addition to being taxable income, excess contributions are subject to a 6 percent penalty tax. However, the penalty tax may be avoided if the employee withdraws the excess amount before the date by which the tax return for the year must be filed.

Contributions by the self-employed. If you are self-employed and contribute to your own SEP-IRA, your contributions as your own employer are essentially limited to a maximum of 20 percent of net earnings (instead of 25 percent of compensation). This is because special rules apply when determining your maximum deduction for your contributions. The maximum compensation you can take into account for the calculation is $255,000 in 2013 ($260,000 in 2014). This amount is subject to adjustment for inflation each year.

Nondiscrimination requirement. An employer who establishes a SEP plan is not actually required to make any contributions to the employees' SEP-IRAs. But if the employer does decide to make contributions to this type of individual retirement arrangement, the contributions cannot discriminate in favor of any officer, shareholder, or highly compensated employee.

For 2013, employer contributions are considered discriminatory unless they bear a uniform relationship to the first $255,000 (subject to annual inflation adjustment) of the total compensation of each employee who has a SEP-IRA. (This amount is $260,000 for 2014.) The IRS has stated that a rate of contribution that actually decreases as compensation increases is considered uniform. Although this may seem like a paradox, the key here is uniformity and equal treatment for all eligible employees.

Example Acme Inc. adopts a SEP plan and is considering how much to contribute for each active employee. For employees with five years of service or less, the company would like to contribute 10 percent of their total compensation for the year. For employees with over five years of service, the company wants to contribute 15 percent of their total compensation. With this contribution scheme, however, the SEP will be considered discriminatory because employer contributions do not bear a uniform relationship to each employee's compensation. Instead, Acme Inc. decides to contribute 15 percent of an employee's first $20,000 in compensation and 10 percent of all compensation above $20,000. This SEP contribution method is not discriminatory, even though the rate of contribution decreases as compensation increases, because it bears a uniform relationship to each employee's compensation.

Coordination with other plans. If an employer maintains one or more defined contribution plans in addition to a SEP, the combined contribution amounts of all the plans have to fit within the overall contribution limit for a defined contribution plan. Although a SEP is not really a defined contribution plan, it is considered to be one for purposes of the overall contribution limit. In 2013, the annual limit for additions to a defined contribution plan is the lesser of 25 percent of an employee's compensation or $51,000. This amount is indexed annually for inflation and increases to $52,000 for 2014.

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